Determining the value of a business is a fundamental concern for business owners. Whether you are preparing your exit strategy, thinking about selling, or learning how to best position yourself for growth and ongoing success, knowing your company’s value is a critical starting point.
What the market demands: the reality vs. the illusion
All too often, business owners see large public companies trading at high Price/Earnings ratios or hear that a friend sold their company for a huge price and assume that they, too, are worth similar levels.
The reality is, these comparisons are often misguided and only serve to set false expectations, which often reduce the likelihood of successfully selling at all.
Valuation: getting real about what your business is worth
To account for the differing levels of debt or cash that a business owner may choose to have, company valuations are typically quoted exclusive of any cash or debt, which is referred to as the Total Enterprise Value. If you go to an accountant and get a formal valuation done, they will use several academic methods for determining your business’ value. These include:
- Cost Approach looks at what it cost to build the company and the replacement cost to arrive at a value. This generally always yields the lowest values and is considered the least instructive method.
- DCF, or Discounted Cash Flow, estimates future cash flows and adjusts for time value. While this method is viable and technically correct, it produces theoretical values that can be divorced from market realities because projections of future performance and the appropriate discount rate are open to interpretation.
- Relative Value takes into account the value of other, similar companies, and precedent transactions. This forms the foundation of market multiples, which will be discussed below. Note that the devil is in the details in terms of determining the proper comparison companies. Because the market changes over time, it is important to use the most recent comparable transactions as possible. It is very similar to valuing a house—you look at the most recent sales of nearby houses and adjust based upon differences (number of bedrooms, square footage, etc.). Also, finding reliable data for small private companies can often be challenging.
Multiple is what matters
In the real world, nearly all transactions are valued using the Relative Value method based upon a multiple of earnings.
A “multiple” multiplies the company’s historical financial performance to arrive at the valuation. For instance, if your company’s annual profits are $2 million and it sells for a multiple of five times earnings, the Total Enterprise Value would be $10 million. While multiples can be applied to any financial metric, the norm is for some kind of earnings level, such as EBITDA or Net Income.
Multiples vary by industry, whose differences can generally be attributed to differences in the expected growth rate and risk levels. Multiples tend to be higher in industries with high growth potential or with lower underlying risk levels.
Having analyzed hundreds of lower middle market transactions, we’ve observed that the vast majority of businesses sell within the range of four to six times earnings, with five consistently being the most common for an average business that grows slowly.
Why? A five-times multiple mathematically coincides with a 20 percent return on investment, which is what most investors are expecting to receive to compensate themselves for the higher levels of risk relative to considering public investment alternatives.
As trite as it sounds, a company is only as valuable as what someone is willing to pay for it. Before taking your business to market, at best you’ll be able to get a range of value, which can be pretty broad. Many things can affect whether you’re at the low or high end of the spectrum:
- Historical earnings are being used as a proxy for what to expect future earnings to be—to the extent that past earnings are not reflective of the sustainable earning capacity of the business, the multiple paid will be impacted.
- Businesses generating stable recurring revenues command much higher multiples than project-based revenue.
- Higher-margin companies typically command higher multiples, as this is assumed to insinuate greater pricing power and resiliency.
- Room for significant cost savings or synergies with strategic buyers can generate higher multiples.
- A highly competitive process with more potential buyers generally results in a full price.
- Urgency to sell versus your ability to be patient to wait for the best offers.
It’s never a bad idea to start immediately to improve your business and its profitability levels. Maximizing its potential by increasing its performance or mitigating key risks adds value regardless of whether you choose to sell or not.